In broad new tax proposals
affecting private corporations, the federal government is on the hunt for
new tax revenue from Canada’s small businesses, mainly because of an
erosion of the personal tax base and a significant shift of taxable income
to the corporate tax base instead.

Specifically, the amount of taxable passive investment income earned by
private corporations has increased from $8.6 billion in 2002 to $26.8
billion in 2015. And the government wants a bigger piece of that pie.

The view is that because small business tax rates are low, any returns made
on passive investments from that capital provide an unfair advantage to the
small business investor. “Preferred tax rates for corporations were never
intended to facilitate passive wealth accumulations, such as through
passive investments,” the Department of Finance says in the recent proposals.

In fact, the private corporation does now pay additional taxes on passive
investment income at a rate that equates to the top tax bracket paid by
individuals. These pre-paid taxes are then refundable when dividends are
paid out to the individual shareholder, who again pays taxes on those
dividends on the personal tax return. The integration of the two tax
systems is almost perfect when a dividend gross-up and dividend tax credit
are combined to reconcile the amounts on the personal return to avoid
double taxation. How perfect that integration is depends on where you live
in Canada.

Passive investments held by small business owners within the corporation as
part of their retained earnings are often parked there in readiness for new
opportunities or as a hedge against other risks. Pre-funding operating
lines, and guaranteeing them personally, are often a pre-requisite for
borrowing, which must be secured by other assets. Investment income earned
also offsets the costs of expensive financing and interest. Yet, the
government compares an investor who is an employee – who bears none of
those risks – with a successful entrepreneur in making a new case for new
taxation.

The assumption is that the business owner would prefer to retain business
income, for passive investment purposes, within the corporation, to reap
tax benefits. However, since the 33% top marginal tax rate was introduced
in 2016, the advantages of earning dividends within a small business
corporation have already been curtailed, when combined personal/corporate
tax rates are considered.

In its proposals, the government presents the case that capital taxed at
low corporate rates within small business corporations and then invested
there, will compound and grow faster, when compared to the investments made
by an individual employee, where tax is lopped off the top, leaving fewer
after-tax dollars for investment purposes. Now proposed is that the
“source” of the earnings used to fund passive investments will be tracked
in the future. Top marginal tax rates will be applied to earnings if the
investment was made with low-taxed corporate dollars.

The proposals are mostly silent on the fact that the individual taxpayer
benefits from the progressive personal tax system – a basic personal amount
and a variety of tax brackets. However, deep in the fine print there is an
acknowledgment that the corporate investor who pays personal tax at a rate
below the top marginal rate, would in the future be incentivized to draw
money out of the business to invest in a personal savings account of some
kind.

For owners of Canadian Controlled Private Corporations (CCPCs) who want to
invest retained earnings to prepare for the next business opportunity, the
news is not good under these proposals, especially if the investment of
choice is publicly-traded securities.

The current system of taxation on portfolio dividends – prepayment of tax
at top tax rates with a refundable tax when passive income is distributed
to shareholders – would be replaced. Instead, all income generated would be
taxed inside the corporation at an amount equivalent to the top personal
tax rates; then once again as “non-eligible dividends” once the money flows
through to the individual. This would apply to both capital gains (the
non-taxable portion of the capital gain would no longer be eligible for
tax-free distribution to shareholders) and dividend income from
publicly-traded securities.

Corporations that only earn income taxed at the general rate could elect to
pay additional non-refundable taxes in return for “eligible” dividend tax
treatment, for which investors receive a higher dividend tax credit
personally. For corporations focused on passive investments – that is, not
set up to earn active income – not much would change under the proposals,
as the earnings are already taxed at the highest rates inside the
corporation.

All of the proposals under discussion would necessitate complex and
expensive annual recordkeeping and reporting, as business owners sort the
capital available for investment purposes into categories of income taxed
at low and high rates before making an investment. Sorting is required
again before distribution to the individual taxpayer, this time through the
pools of eligible dividends, non-eligible dividends and tax-free dividends.
If the changes do take effect as described, they will significantly raise
taxes on new passive income investing activities within the corporation,
making that option prohibitively expensive.

With the current tax system, the tax rate would be 50.4% (assuming perfect
integration). So the proposals obviously represent a huge tax increase.

Alternatively, the personal tax system offers progressive tax rates, 50%
capital gains treatment, and the opportunity to have dividends from
publicly-traded securities taxed as “eligible” rather than “ineligible.”
Small business owners will no longer be incentivized to park retained
earnings within the corporation if their income falls below top personal
tax brackets in the future. In that case, distributing corporate earnings
as salary or dividends in order to make passive investments personally will
make more sense. In the process, complex and expensive tax preparation
costs within the corporation will also be avoided.

What will happen to the large existing pools of passive investments within
private corporations if the changes as proposed should come to pass?
Business owners with retained earnings subject to low corporate rates may
wish to make passive investments inside the corporation now to avoid the
punitive new rules after the proposals take effect. After public
consultations end on October 2, 2017, there is a promise in the proposals
that “time will be provided before any such proposal becomes effective.”
However, there is no guarantee on the effective date of change.

Whether this leaves the business itself at a disadvantage remains to be
seen. Planning is required to determine “what if” scenarios now. In
addition, tax and financial advisors will want to work together with
business owners to understand the effect of the proposed changes on family
compensation planning, business succession planning and debt and cash flow
management.

The foregoing is for general information purposes only and is the opinion
of the writer. No guarantee of investment performance is made or implied.
It is not intended to provide specific personalized advice including,
without limitation, investment, financial, legal, accounting or tax advice.